Bad loans as a proportion of total lending jumped to a
record 10.5 percent in August from a restated 10.1 percent in
July as 9.3 billion euros ($12.2 billion) of loans were newly
classified as being in default, according to data published by
the Bank of Spain on its website today. The ratio has climbed
for 17 straight months from 0.72 percent in December 2006,
before Spain’s property boom turned to bust.

Spanish bank stress tests by management consultants Oliver
Wyman have factored in an economic contraction totaling 6.5
percent from 2012 to 2014 in an adverse scenario that the
government and Bank of Spain said has a probability of about 1
percent. Analysts at Nomura and Citigroup Inc. disagree, saying
spending cuts and economic conditions mean the worst-case
outcome already looks feasible.

“You can’t attach a 1 percent probability to a scenario
that already looks realistic,” Silvio Peruzzo, a European area
economist at Nomura in London, said in a telephone interview
yesterday. Spain’s gross domestic product will shrink by 6.2
percent from 2012 to 2014, he estimated.

Spain Downgrade

Spain’s request for 100 billion euros of European Union
financial aid to shore up its banks is increasing concern about
the nation’s growing liabilities. Standard & Poor’s downgraded
the country’s debt rating by two levels to BBB-, one step above
junk, from BBB+ on Oct. 10, saying it wasn’t clear who will bear
the cost of recapitalizing banks.

It cut the ratings of 11 lenders including Banco Santander
SA and Banco Bilbao Vizcaya Argentaria SA, Spain’s largest, two
days ago, citing the sovereign downgrade.

Lending in Spain’s banking system fell 1.1 percent in
August from July and 5 percent from the same month a year
earlier, the Bank of Spain said. Deposits dropped 1.1 percent in
the month and 8.7 percent from a year ago.

Economic Growth

Under Oliver Wyman’s worst-case projection, an economic
contraction of 4.1 percent in 2012, 2.1 percent in 2013 and 0.3
percent in 2014 would contribute to 270 billion euros of credit
losses and a 59.3 billion-euro capital shortfall for banks. The
base case foresees shrinkage of 1.7 percent this year, 0.3
percent in 2013 and an expansion of 0.3 percent in 2014. A
deeper recession poses the risk that banks will have to raise
more capital to cover losses.

Oliver Wyman won’t comment on estimates laid down in the
stress tests, an official at Llorente y Cuenca, a Madrid public-relations firm representing Oliver Wyman, said in a telephone
interview yesterday.

Spain commissioned the review as part of terms for its
European bailout. Oliver Wyman said in its report on the stress
tests that a steering committee that included the European
Central Bank and the International Monetary Fund had deemed its
adverse scenario conditions to be “appropriately conservative”
relative to Spanish macro-economic indicators over 30 years.

Spanish banks’ loan losses will continue to grow because of
the deteriorating economic outlook and rising unemployment, said
Ebrahim Rahbari, a London-based economist at Citigroup. He
predicted a 5.8 percent contraction for Spain’s economy between
2012 and 2014.

Adverse Scenario

“The adverse scenario of the test looks closer to a
forecast of economic performance over the next three years than
a stress case,” Rahbari said in a phone interview. “That
surely has consequences for loan-loss rates and the one we are
most concerned about is household mortgages.”

Deutsche Bank AG says the economic slump in Spain will be
less pronounced, predicting a 1.7 percent decline in GDP over
the period. The economy will grow 0.7 percent in 2014 after a
2.6 percent slump this year and in 2013, the bank said.

In a Bloomberg survey of 37 analyst estimates for Spanish
economic growth, the average forecast is for a drop of 1.6
percent in GDP this year and 1.4 percent in 2013, followed by
growth of 0.2 percent in 2014.

“A contraction of 2.6 percent over two years is still a
hell of a contraction,” Gilles Moec, Deutsche Bank’s co-chief
European economist in London, said by telephone yesterday. A
pledge by European Central Bank President Mario Draghi to help
bring down Spanish borrowing costs will probably help Spain
avoid being sucked into a recessionary “spiral,” he said.

Rising Defaults

The default rate for 604 billion euros of Spanish home
mortgages stood at 3.2 percent in June, according to the Bank of
Spain. Banco Santander Chief Executive Officer Alfredo Saenz
said in April that anyone saying mortgage defaults are a problem
for Spanish banks was “saying something stupid.”

“I think this drop of 6.5 percent is a number that isn’t
going to happen,” said Maria Dolores Dancausa, chief executive
officer of Spain’s Bankinter SA, referring to the adverse macro-economic stress test scenario at a Madrid news conference today.

Loans newly-classed as in default fell in the third quarter
for Bankinter, said Chief Financial Officer Gloria Ortiz on a
webcast for analysts today after the bank published earnings.
“We cannot say this is a trend,” she said. “The economic
situation is complex so I would be prudent and expect further
deterioration of the book next quarter and throughout 2013.”

Jobless Rate

Bad loans and the jobless rate are bound to increase as
Spain attempts to cut its budget deficit to 2.8 percent of GDP
in 2014 from 9 percent at the end of last year, Simon Maughan, a
financial industry strategist at Olivetree Securities in London,
said last week by telephone.

In the worst case scenario, Oliver Wyman’s stress tests
predict unemployment of 25 percent this year rising to 27
percent in 2014. The rate will peak at 26 percent in 2013,
according to the average estimate in a Bloomberg survey of 13
analysts.

It may be wrong to suggest, as the Spanish authorities do,
that the higher rates of economic contraction estimated by
Oliver Wyman are a remote possibility, said Daragh Quinn, a
Madrid-based banks analyst at Nomura.

“I think that talk of 1 percent probability is going to
come back to haunt them,” Quinn said in a phone interview.

The bad loans data published today by the Bank of Spain
restated the bad loans ratio for July to 10.1 percent from a
previously published 9.86 percent. The amount of bad loans for
July was restated to 173.2 billion euros from a previously
published 169.3 billion euros.